Dividend-paying, Cash Value life insurance provides Canadians with a tax-preferred option to broaden their asset mix
Background
Participating Whole Life Insurance – a type of life insurance policy that never expires, regardless of how long the insured lives for. These policies have two components:
- Death Benefit
- Cash Value
Cash Value – this is the investment or savings component of a participating whole life insurance policy. The cash value grows by way of dividends from the insurance company (more on this below) and exempt policies require no annual tax reporting – much like a RRSP.
Cash value can be accessed three ways:
- Policy Loan
- Withdrawal
- Using the cash value as collateral to secure a 3rd party loan
The insurance company manages the cash value of all policyholders. Deposits from participating whole life payors goes into the insurer’s “participating account” – this account covers expenses, taxes, insurance claims, among other items. The participating account funds are also invested by the insurance company’s professional asset management team. Dividend distributions to policyholders will reflect the participating account’s investment performance, as well as the items mentioned above – notably claims experience. While dividends are not guaranteed, Equitable Life (for example) has issued a dividend every year since 1936 – the same year they introduced their participating whole life product.
The policyholder has multiple options in terms of what to do with their dividend distributions (the specifics are beyond the scope of this article), but the most common and tax-effective method is to allow the dividends to accumulate within the policy’s cash value.
Case study: Michael
Objective
Michael is looking to diversify his asset mix – his current portfolio consists of real estate, as well as RRSPs & TFSAs holding a blend of stocks, ETFs and bonds. Michael has a family that relies on him financially.
Relevant facts
Michael is a 45-year-old male with no tobacco usage in the past 12 months. He reports no major health concerns in the past. He is looking for a policy that will provide him with enough cash value to supplement his income during retirement or provide him with access to capital for future investment opportunities. He has a need for $250,000 of life insurance.
Financials
Michael will deposit $10k per year into the policy over the next twenty years. At age 65, the policy requires no further deposits from Michael. This is referred to as a 20-pay participating whole life policy.
Here is how the numbers project*:
| Death Benefit | ||
| Guaranteed | Projected | |
| Age 55 | $ 250,000 | $ 334,000 |
| Age 65 | $ 250,000 | $ 464,000 |
| Age 75 | $ 250,000 | $ 644,000 |
| Cash Value | ||
| Guaranteed | Projected | |
| Age 55 | $ 78,000 | $ 112,000 |
| Age 65 | $ 145,000 | $ 260,000 |
| Age 75 | $ 183,000 | $ 446,000 |
*numbers courtesy of RBC Insurance
Guaranteed vs. Projected – Explanation
When Michael applied for his policy, he was provided with contractual guarantees for the death benefit and the cash value. These will not fluctuate or change, they are set in stone and serve as the baseline.
The 2nd set of relevant numbers include the “projected” outlook for the death benefit and cash value over time. These are based on the current landscape – if everything stayed the same for the insurer’s participating account, this is how the values would look. These numbers will undoubtedly fluctuate up and down; the purpose of the “projected” numbers is to provide Michael with a ballpark look of what he can expect in the future.
Cash Value – potential uses
Scenario 1
At age 55, Michael decides he would like to pursue an investment opportunity costing $50,000. He does not want to have to sell from his investment portfolio to access the $50k, so he will utilize his policy’s cash value. At the time, the cash value sits at $110,000. Michael decides to use the policy as collateral and assigns it to a 3rd party lender in return for a $50,000 loan. Michael’s interest payments on the loan are tax-deductible since the $50k is being used to earn investment income, and the loan proceeds are received on a tax-free basis.
Because Michael leveraged the policy instead of withdrawing directly from the cash value, the entirety of the cash value remains at $110,000. The only implication of this transaction is that the 3rd party lender has a $50,000 claim on Michael’s death benefit if he were to pass away with the loan outstanding. Example below:
| Death benefit at age 55 | $334,000 |
| LESS: amount owed to 3rd party lender | ($50,000) |
| NET amount received tax-free by Michael’s beneficiary | $284,000 |
If Michael did not have this cash value at his disposal, his options would have been limited to selling other assets (with adverse tax consequences) to fund the $50,000 investment opportunity.
Scenario 2
Michael has reached his retirement age of 65. While he has a stable income through retirement, he would like to use his policy’s cash value to supplement his lifestyle. Similar to scenario 1, Michael will leverage the cash value to secure a loan with an outside lender. The lender will provide Michael with $25,000 per year for a period of 10 years. Much like Scenario 1, the annual $25,000 is received on a tax-free basis. Due to Michael’s other assets, credit rating and loan amount, the lender allowed him to capitalize the interest on the loan.
Although the death benefit will be reduced by the 3rd party loan, Michael maintains an adequate amount of insurance coverage to provide for his family’s income needs and cover his final expenses.
At age 85, Michael passes away – the death benefit is projected to be at $905,000. The lender gets reimbursed for the loan, and the remainder flows tax-free to Michael’s beneficiary.
Summary
When considering alternate assets, participating whole life insurance makes sense for Michael for the following reasons:
- Death benefit coverage for his family – If something were to happen to Michael, his beneficiary would receive the tax-free death benefit.
- Professionally managed asset – Michael does not have to worry about the cash value investment decisions.
- Tax-preferred growth – by reinvesting the policy’s dividends, Michael is growing his cash value on a tax-sheltered basis.
- Diversification – The insurer’s participating account is invested in a wide array of financial securities and gives Michael exposure to different segments.
- Reduced volatility – The dividend scale interest (DSIR), which is integral in determining the dividend issued to Michael, is smoothed over a long period of time to reduce fluctuations in the dividend. Here is an example from Equitable Life during the 07/08 financial crisis:
| Year | Equitable DSIR | TSX Index |
| 2008 | 7.90% | -33% |
| 2009 | 7.40% | 35% |
- Ability to access the cash value via 3rd party loan – While Michael can withdraw funds directly from the cash value or take out a policy loan with the insurer, he also has an opportunity to collateralize the policy with an outside lender. This allows him to receive tax-free money from the cash value and it also keeps the full amount of the cash value intact, leading to continued maximum dividend earning potential. There are companies in Canada who specialize in this type of lending.
- Protection against creditors – By naming his spouse as the beneficiary, Michael has creditor-protected the death benefit and the cash value.
For more information or to get started with this concept, contact Jeff Graham at (604) 363-7549 or jeff@firstoakfinancial.ca.
DISCLAIMER: this commentary is provided for general informational purposes only and does not constitute financial, insurance, investment, tax, legal or accounting advice. The numbers projected can fluctuate based on a wide variety of factors and approval for an insurance policy is not guaranteed. Always seek advice from your tax and/or legal advisors prior to implementing these strategies.